When the European Union made strenuous efforts to contain the sovereign debt crisis in the smaller and peripheral European states of Greece, Portugal and Ireland by offering bailouts, it was cognizant of the risk of contagion. By showing its determination in the manageable countries, the European Union was hoping to deflect concern about the major economies that were in financial trouble, These are mainly Spain and Italy.
This policy had a corollary- if the handling of the financial situation in the small countries was suspect or dodgy, this would eventually raise questions about the major countries in financial trouble.
The European Union has faced a re-eruption of the Greek debt crisis and has yet to put the final touches on the second bailout. Portugal had its bonds marked down to junk by the credit rating companies.
Italy is contending with political instability since the recent electoral setbacks to the government. Italian Premier Silvio Berlusconi picked perhaps the most inappropriate time to place a question mark on the future of his finance minister Giulio Tremonti. "He is the only minister who is not a team player."
This gave the impression that the finance minister would soon be booted off team Berlusconi. In Italian finance, Tremonti is a reassuring face to investors. Only two weeks ago he unveiled a cost-cutting program a €47 billion designed to balance the budget by 2014 as well as to reissue reassure investors and keep Italy's A+ credit rating.
The fear that the already unstable Italian government would be imminently losing its economic helmsman triggered a mini panic that was reflected on the stock exchanges of Italy and Europe. Italy's Unicredit bank fell by 20% last week and the decline continued today. Some blue chips such as Fiat had trading suspended due to the gravity of losses.
Italy's citizens are generally frugal and pay by cash rather than by credit card (also to dodge taxation). The big debt problem in Italy is government debt. The country's debt amounts to $1.8 trillion of which 26% must be refinanced in 2011 and 2012.
As Italy has displayed stagnant growth for the past decade, impervious to governments of the left or the right, has a low degree of competitiveness and a low birth rate, analysts are questioning how Italy will be able to service its debts.
This in turn creates a vicious cycle: The greater the pessimism that Italy cannot repay its debts the higher the cost of borrowing becomes fueling further pessimism on till an explosion occurs.
Italian bonds have fallen heavily. This is what is eventually forced Greece then Ireland and finally Portugal to seek shelter in a bailout. If the contagion reaches Italy and Spain it is difficult to see how the problem can be surmounted.